The Worst Kind of Deja Vu

According to 18th-century philosopher Edmund Burke: "Those who don't know history are destined to repeat it." With the American financial system in utter turmoil, history will now show that the lessons of the Great Depression were sadly forgotten.

This week's move by the Federal Reserve to reclassify the last two independent brokerage firms -- Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) -- as bank holding companies represents the final nail in the coffin of the regulatory reforms instituted at the end of the last great financial meltdown. The new rules permit these institutions to access the Fed's discount window in perpetuity, to build out a nationwide bank network with FDIC-backed deposit accounts, and to allow many types of investors to hold major ownership stakes in bank holding companies.

These are extraordinary developments to be sure, but the roots of the underlying financial crisis can actually be found in the gradual erosion of reforms that were created some 75 years ago. The financial world looks very different this time around, but on a fundamental level, history is most assuredly repeating itself.

The cycle beginsIn the aftermath of the 1929 market crash, market speculation by financial institutions was widely considered one of several culprits. Demand for financial reforms led two Congressmen to sponsor a bill bearing their names that would insert a line of separation between companies engaged in retail banking and lending activities, and those underwriting securities and other types of instruments. Under the Glass-Steagall Act, enacted into law in 1933, you could either be a bank or a brokerage … but not both.

In 1956, Congress added the Bank Holding Company Act, which further restricted bank holding companies from engaging in non-banking activities or acquiring major ownership stakes in other types of financial companies. The common sentiment behind both of these acts appeared to be an aversion to exposing depositors and taxpayers to the type of excessive leverage and risk that characterized the financial industry in the run-up to the Great Depression. With these measures in place, I'd guess Congress sincerely believed that another financial meltdown of that caliber would never be possible again.

Cracks start formingFast forward to the 1960s and 1970s, when lobbying efforts to repeal Glass-Steagall began to take form, and some brokerage companies were permitted to offer money-market accounts and a few other bank-like services.

In 1987, the Federal Reserve was pressed by the predecessors of Citigroup (NYSE: C) and JPMorgan Chase (NYSE: JPM) to permit banks to deal in commercial paper, mortgage-backed securities, and other instruments. To pass this measure, the Fed board overrode the opposition of Chairman Paul Volcker with a 3-2 vote.

When Alan Greenspan took over later that year, the banks finally had their man. In 1989, the Fed voted to permit banks to deal specifically in debt and equity securities. After all, what harm could that do … right?

During the 1990s, Glass-Steagall was tweaked to permit banks to derive 25% of revenue from brokerage activities. Soon after, the predecessor of The Travelers Companies (NYSE: TRV) announced a merger with Citicorp, and the full-court press to repeal Glass-Steagall was on.

Congress first passed a law permitting huge financial conglomerates. Then, in 1999, it added the Financial Services Modernization Act. That watershed law paved the way for the emergence of financial superconglomerates like American International Group (NYSE: AIG) and Bank of America (NYSE: BAC) , and permitted the systemic cross-hybridization of bank holding companies, brokerages, insurance companies, and more.

A crisis opens the floodgatesFools know precisely how this brief experiment with a deregulated financial sector has turned out. Staring into the face of financial ruin, the Federal Reserve and the Treasury have responded with all manner of liquidity injections, loans, bailouts, and rule changes. For the second time in history, the brokerage industry has proved a potentially destabilizing speculative force in the financial sector.

With this week's move to treat Goldman Sachs and Morgan Stanley as banks, it seems we're headed back toward the troubles that brought us here in the first place. Perhaps the wiser move would be to reinstall some boundaries between lending institutions and underwriting businesses, and maybe even bring back that discarded post-Depression relic called Glass-Steagall. Perhaps then we'd have fewer companies that are "too big to fail."

When the dust settles from this crisis, Fools can rest assured that a new era of financial regulation will be heralded as protection from any such catastrophe ever recurring. My only request is that Fools teach this story to their children and grandchildren. As we've just learned, once history is forgotten, it's only too easy to repeat it.

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I always look forward to your writings, as they are usually very thorough. But you missed one key piece of legislation that essentially gutted the Glass-Steagall Act of 1933. It was the Gramm-Leigh-Bliley Act of 1999 (November). I'd blogged about it a week ago, here on the Motley Fool, if you care to take a look:

The bailout is going to cost all of us and our children an amazing amount of money in the future. We as a country just can not afford to continue adding to a national deficit of what will be more than $11 Trillion by the end of this year.

We fully understand the implications of no bailout. It is pretty much guaranteeing at this point that we and the rest of the world will drop into a 1930's type....

Here is the roll call vote from the House for resolution 3997 - the "Bailout". Now you can find out whether or not you need to call your Representative to tell him he's being voted out if he votes in favor of this again when it comes up for the next try. I already called Ike Skelton to tell him I'm voting for his opponent in the next election: